FOREIGN EXCHANGE
MARKET
(FOREX, FX)
HOW MANY CAN YOU NAME?
 On the poster, write as many names of foreign currencies that
you know
FOREIGN EXCHANGE MARKET
 Definition = a market in which various national currencies are
exchanged for one another
 The equilibrium prices in these markets are called exchange
rates
 The rates at which the currency of one nation can be exchanged for
the currency of another nation
FOREIGN EXCHANGE MARKET
 Two things to keep in mind:
 1) It is a competitive market
 The market is characterized by large numbers of buyers and sellers
dealing in standardized products (American dollar, European euro,
British pound, Japanese yen)
 2) It links all domestic prices with foreign prices
 Consumers only need to multiply the foreign product price by the
exchange rate
 Example = if the U.S. dollar to Japanese yen exchange rate is $0.01
per yen, then a TV priced at ¥20,000 will cost $200
 20,000 * 0.01
FOREIGN EXCHANGE MARKET
MR. CLIFFORD
 Mr. Clif ford
DEPRECIATION VS. APPRECIATION
 Depreciation = a decrease in the value of a currency ( weak
dollar)
 Example = an increase in the demand for Japanese goods (Toyota
cars) here in America will increase the demand for yen and raise the
dollar price of the yen.
 Our dollar has depreciated in value because it can buy fewer yen (the
Toyota cars have become more expensive to U.S. buyers)
 Appreciation = an increase in the value of the currency ( strong
dollar)
 Example = an increase in Japanese demand for American goods (Ford
trucks) will increase the demand for dollars and raise the yen price of
our dollar
 The decrease in the dollar price of the yen means it takes fewer
dollars to buy more yen
HELPFUL PICTURE
FIXED VS. FLOATING RATES
 Fixed rate = the exchange rate stays the same
 In the past the rate was set by gold (Gold Standard)
 Central banks set the rate – rarely worked
 Used until WWI
 Floating rate = based on supply and demand for each currency
 The International Monetary Fund (IMF) regulates monetary
stability and helps promote foreign trade
ASSUMPTIONS
 Assumptions related to
exchange rates:
 If the demand for a nation’s
currency increases (all else
equal), that currency will
appreciate. If demand
declines, it will depreciate.
 If the supply of a nation’s
currency increases, that
currency will depreciate. If
supply decreases, that
currency will appreciate.
 If a nation’s currency
appreciates, some foreign
currency depreciates
relative to it.
 Determinants of exchange
rates:
 Consumer Tastes
 Relative Income
 Relative Inflation
 Speculation
RELATIVE INCOME
 When one nation’s macroeconomy is strong and incomes are
rising, ceteris paribus, demand for all goods increases,
domestically and abroad
 Ex: if Europeans are enjoying economic growth and
the US is in recession, the relative buying power of
European Citizens is growing. They will increase their
consumption of domestic and US made goods.
(demand for USD increases, USD appreciates)
 Ex: England encounters a recession, reducing its
imports, while US real output and real income surge,
increasing US imports (British pound appreciates,
USD depreciates.
RELATIVE PRICES (INFLATION)
 If one nations’ price level is rising faster than that of another
nation, consumers seek the goods that are relatively less
expensive.
 Switzerland experiences a 3% inflation rate compared to Canada’s
10% rate (Swiss franc appreciates; Canadian dollar depreciates).
 If European inflation is higher than inflation in the US, American made goods are a relative bargain to German consumers and the
dollar appreciates. (Another reason for the Fed to keep inflationary
pressure low!)
SPECULATION
 Foreign currency is traded as an asset and investors seek to
profit from buying currency at a low rate and selling it at a
high rate
 Ex: If it appears that future US interest rates will fall relative to the
rates in Japan, the Yen begins to look like a great investment
(speculators increase demand for Japanese assets, thus appreciating
the Yen and depreciating USDs)
 Ex: Currency traders believe South Korea will have much greater
inflation than Taiwan (South Korea won depreciates; Taiwan dollar
appreciates)
 Ex: Currency traders think Finland’s interest rates will plummet
relative to Denmark’s rates (Finland’s markka depreciates;
Denmark’s Krone appreciates)